Reducing Unemployment by Monetary Expansion - Example

Aggregate demand II Student’s name Institution Introduction It is the role of government to control economic performance. Two main policies are used in controlling economic performance; the monetary and physical policies. Under the monetary policy, the government controls economic performance through adjusting money supply while under the fiscal policy, economic conditions are controlled by regulating government expenditure. The two are controlled through two markets; the goods market also known as the product market and the money market where the goods market is represented by the Investment Savings function while the money market represented by the Liquidity Money function (Abel 2001). The IS and LM curves as demonstrated by the below graph. r LM IS The best policy to stabilize output when external shocks changes the demand for goods and services. Economic shocks that arise from exogenous changes on the demand for goods and services leads to an outward shift in the IS curve. Increased demand for goods and services comes as a result of more money in circulation in the economy since income is an increasing factor of the demand for goods and services. The best policy to control this excess demand for goods and services is by adjusting the quantity of money supply while holding the interest rate constant. Contraction fiscal policy can be used to reduce the quantity of money supply in the economy. Reducing government expenditure on goods and services will reduce the level of income earned by individuals (Sloman 2003). As income increases, the demand for goods and services increases while as income reduces; individuals reduce their level of consumption for goods and services. The reduction of government expenditure will shift the investment demand function (IS curve) backwards to the original equilibrium and hence output stabilized. The following graph demonstrates the situation. r LM IS y The best policy to stabilize output if external shocks lead to changes in the demand for money Individuals demand more money when the interest rates are low. This is because, the low interest rates gives low returns and so people are discouraged from saving their money and also borrowing money from the bank is cheap when the interest rates are low. The increase in money demand makes the LM curve to shift leading to disequilibrium in the product and money market. The best policy to stabilize output under this situation is by adjusting the interest rates while holding money supply constant (Williamson, 2005). This can be done by applying monetary policy where the interest rates are raised so as to discourage individuals from borrowing while encouraging them to save their money due to the high levels of returns arising from high interest rates. The increase in interest rates will lead to an increase in savings which will reduce the level of money in circulation in the economy and hence shifting the LM curve upwards to the original equilibrium, stabilizing the output (Mankiw, 2007). The following graph demonstrates the situation. r LM IS y Aggregate supply and Philips curve Augmented Philips curve and the long run Philips curve The Philips curve shows an inverse relationship between unemployment and inflation. Augmented Philips curve shows the combination between unemployment and inflation in a given time while a long run Philips curve shows how inflation and unemployment are not related in the long run. Structural unemployment is when people cannot secure jobs due to inappropriate skills as required in the available jobs. If the Australian government implements the strategy of helping unemployed workers acquire new skills so as to secure jobs and this reduces structural unemployment in the economy, the following effect will be felt (Dougall, 2013). On the expectations- augmented Philips curve On the expectations –augmented Philips curve, the strategy will increase the rate of inflation as structural unemployment increases. This is because; the reduction in unemployment which is increase in employment opportunities will lead to an increase in income. The increase in individual’s income will lead to increase in demand for goods and services. According to the law of demand, an increase in quantity demanded leads to an increase in price and so the general price levels will increase leading to inflation in the Australian economy (Samuelson 2001). On the long run Philips curve The strategy will reduce unemployment in the short run. As people continues securing jobs and the level of income keeps on increasing, the demand for goods and services keeps on increasing while inflation keeps on increasing, it will result to very high inflation in the long run. Because of high price levels in the economy, the demand for goods and services in the Australian economy will reduce since individuals will start purchasing goods and services from other countries. The reduction in demand for goods and services in Australia will lead to decrease in investments. The existing investors will be discouraged because of the minimal demand which will make some industries to collapse. This will then result to low employment opportunities in Australia leading to increased unemployment again. The strategy will therefore have no effect in the long run (Dornbusch 2010). Reducing unemployment by monetary expansion Monetary theory can also be used to cut the problem of unemployment in the economy. With monetary expansion, the borrowing rates are reduced which encourages investors to borrow money from bank for business expansion purposes or starting new businesses. This will increase the employment opportunities in Australia and hence reducing the unemployment problem. However, unemployment will be reduced only in the short run. After some time, as money supply increases in the economy, the aggregate demand for goods and services will increase (Brooman 2006). As money supply increases with more employment opportunities increasing, there will be excess demand for goods and services in the economy resulting to disequilibrium in the goods market. The excess demand for goods and services will lead to an increase in prices so as to restore the economy back to equilibrium. As the price increases, the demand for goods and services will reduce in the economy which will be followed by a reduction in investments. Reduction in investment will lead to a reduction in employment opportunities in the economy leading to high levels of unemployment in the Australian economy (Bodie 2005). This monetary expansion strategy will also be ineffective. Therefore, the two policies, monetary policy and fiscal policy must be used together for effectiveness. One cannot function effectively without the other. Effects of the Taylor’s principle of increasing policy rate targets under positive output gap on demand pull inflation Output gap is the difference the real output in the economy and the optimal output that can be achieved at an efficient capacity. Positive output gap occurs when the realized or the real output becomes more that the potential output and it mostly occurs in economic boom. Demand pull inflation happens when interest’s rates are low and people can access funds accompanies by some purchasing offers which increases the demand for goods and services. This results to excess demand in the goods market which results to inflation (Blanchard 2010). When the realized output is more than the potential output (positive output gap), it is an indication that there will be a lot of money in circulation. Increasing policy rates encourages individuals to save their money due to the high expected returns resulting from the high policy rates. In addition, the increased policy rates will discourage investors from borrowing funds from banks which also reduces the money supply. The policy will in the long run reduce money supply in the economy (Abel 2001). With low money in circulation and low investments due to the increased policy rates, individuals will reduce the demand for goods and services creating disequilibrium in the goods market where there will be excess supply of goods and services. In restoring the market back to equilibrium, the price will be reduced so as to enable suppliers supply their excess goods and services (Bodie 2005). The reduction in price levels will lead to a slight reduction in inflation only in the short run but increase the inflation rate in the long run. The limitation of Taylor’s rule with respect to demand pull inflation Taylor’s principle reduces demand pull inflation only in the short run while increases it in the long run. The increased interest rates which increase the rates of savings will result to increased investments in the long run. The reduction in prices with increased investments will result to increased demand for goods and services in the long run. This is because; the increased investments will create more employment opportunities resulting to more income and hence more demand for goods and services. The excess demand in the market will therefore again result to increased demand pull inflation (Williamson 2005). Consumer behavior Average propensity to consume is the level of income an individual uses in consumption rather than in savings. The Keynesian theory of consumption provides that the average propensity to consume (APC) decreases as the income increases. Implication of the Keynesian theory of consumption on the average propensity to consume for poor countries Individuals in developing countries or poor countries have low levels of income. With low levels of income, it is a challenge for them to satisfy all their needs especially the basic needs. Given this reason, an increase in income in the poor countries leads to an increase in consumption since individuals tries to meet their basic needs such as food, clothes and shelter. As income increases in poor countries, the level of increase in consumption reduces with a decreasing rate (Dougall 2013). The average propensity to consume in such countries is therefore more than zero but less than one. (0>APC Read More